The major U.S. banks passed their stress tests with flying colors recently, sending bank shares soaring. But it isn’t just those banks that are doing much better. Global investment banks in general are showing signs of much greater stability, and as legacy litigation risks such as the cases related to mortgage-backed securities continue to fade, their capital positions will continue to improve.

All tested U.S. banks pass stress test

All 34 of the U.S. banks that underwent stress tests this year passed them, although CNBC highlighted that there were still some winners and losers from those stress tests. It means that they have what the Fed considers to be enough capital to withstand sudden shocks. The media outlet named Goldman Sachs, Regions Financial, CIT Group and Citigroup as the potentially big winners among firms likely to return more than 100% of their earnings to investors. This behavior signals great confidence, not only on the part of the banks themselves but also among regulators, who have to approve their capital return plans.

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Immediately after the results of the stress tests were released, bank stocks climbed, but then only a day later, they turned lower. The Financials sector underwent a remarkable shift on the stock market, going from being one of the best performers when the markets opened on June 23 to being one of the biggest drags on benchmark indexes after investors had time to really think about the results of the stress tests.

Investment banks stabilize themselves

Moody's notes that one major contribution to this growing stability among global investing banks is the steady decline in legacy litigation risks.

In a report earlier this month, a Moody's team led by Senior Vice President Alessandro Roccati outlined the steady decline in legacy litigation risks over the last 18 months. They note that most of the global investment banks their firm has assigned a credit rating to have been able to grow the proportion of earnings they get from their retail, corporate and wealth management franchises.

Such earnings tend to be more stable, and thus, they enable these investment banks to absorb any sudden hits from large charges, such as those caused by litigation. This is a huge positive for the banks' bondholders, although the Moody's team looked beyond the current improvements to consider the possibility of future litigation charges.

Provisions on the decline due to receding legacy litigation

According to Roccati and team, investment banks have rolled back their provisions for litigation since 2015 because most of their legacy litigations have already been settled. U.S. and European investment banks in particular have settled most of their legacy litigation. In aggregate, litigation provisions stood at $19 billion last year, meaning that the banks almost sliced their provisions in half from the $33 billion held in 2015.

legacy litigation

This brings the investment banks' total legacy litigation provisions between the 2008 global financial crisis and 2016 to $273 billion. About half of those total provisions were connected to lawsuits around residential mortgage-backed securities. The second-biggest category was mis-selling and misrepresentation, which was about a third of the total.

legacy litigation

Some legacy litigation risks do still remain...

Although the investment banks have made a lot of progress, the Moody's team explained that there are still some residual legacy litigation risks, especially among European firms. Most of these risks are related to residential mortgage-backed securities, and Moody's notes that RBC, Barclays, HSBC and UBS still haven't settled their large legacy litigations around RMBS in the U.S. However, they have already set aside for provisions to settle these cases or accounted for the cases in their capital plans.

Other major legacy litigation risks are specific to countries. For example, the firm notes that Deutsche Bank is still be investigated for its Russian "mirror" trading, while Barclays still faces risks related to its 2008 rights issue disclosures.

...But those risks are mitigated

However, the Moody's team adds that the world's investment banks have seriously improved their capacity to absorb shocks and have boosted their capital basis. This mitigates the financial risk associated with the pending cases against them. Unfortunately, the banks may still be at risk for future litigation as well.

legacy litigation risks

The banks are much more stable now, as retail, corporate and wealth management earnings tend to be safer than earnings from businesses that have greater exposure to the capital markets due to the extreme volatility these markets often face. Thus, these safer earnings will enable the investment banks to restore their capital levels in the event that a surprise litigation charge occurs.

Additionally, investment banks' capital positions have just generally improved, as the media common equity tier 1 ratio rose to 12.5% last year from 10.1% in 2013. Reduced low-yielding and loss-making divisions have helped improve their capital positions.

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